Learning Outcomes
- Understand the effects of sale mix on fixed costs
Here again, are five basic questions to address as you contemplate segments with regard to the sales mix:
- Does the segment have a positive contribution margin?
- What happens to fixed costs if we eliminate a segment?
- How will dropping a product or segment affect other areas of the business?
- What can the company do with freed-up capacity?
- What are the qualitative (non-financial) considerations?
We looked at what would happen to the company if it dropped the HighLine model, but we did not take into account what might happen with fixed costs.
Question 2: What happens to fixed costs if we eliminate a segment?
We have this information with regard to fixed costs per month:
Description | Total |
---|---|
Sales Salary | $ 10,000 |
Selling, General, and Administrative | 90,000 |
Production Facility Rent | 10,000 |
Single Line$ 110,000Double line |
Let’s say we decide to allocate sales salary and SG&A based on the number of units of each model sold, and production facility rent based on the number of square feet each model occupies. You have this information:
Production facility usage | MidLine | HighLine | LowLine | Total |
---|---|---|---|---|
Square feet | 5,000 | 4,000 | 1,000 | 10,000 |
Allocation rate | 50.00% | 40.00% | 10.00% | 100.00% |
The Midline production operation takes up half of the available space in the production facility, so we allocate half of the rent to that segment, and 4,000/10,000 of the rent to HighLine, and so on.
For rent and sales salaries, we have decided to allocate costs based on units sold. We would choose whatever base made the most sense for a particular business—and that was cost-effective to collect the data on. In this case, we can get the units sold very easily, and we can make a logical argument that fixed costs could be allocated on that basis.
Sales Salaries and SG&A | MidLine | HighLine | LowLine | Total |
---|---|---|---|---|
Unit sold | 60 | 10 | 20 | 90 |
Allocation rate | 66.67% | 11.11% | 22.22% | 100.00% |
Allocating based on these assumptions, and rounding to the nearest whole dollar, we get the following:
Fixed costs per month | MidLine | HighLine | LowLine | Total |
---|---|---|---|---|
Sales Salary | $ 6,667 | $ 1,111 | $ 2,222 | $ 10,000 |
Selling, General, and Administrative | 60,000 | 10,000 | 20,000 | 90,000 |
Production Facility Rent | 5,000 | 4,000 | 1,000 | 10,000 |
Single Line$ 71,667Double line | Single Line$ 15,111Double line | Single Line$ 23,222Double line | Single Line$ 110,000Double line |
This then gives us this revised CVP analysis:
MidLine | HighLine | LowLine | Total | |
---|---|---|---|---|
Subcategory, Assumptions | ||||
Sales price per unit | $6,500 | $11,000 | $4,000 | |
Variable cost per unit | $4,695 | $12,050 | $3,180 | |
CM per unit | Single Line$1,805Double line | Single Line($1,050)Double line | Single Line$820Double line | |
Fixed costs per month | $71,667 | $15,111 | $23,222 | $110,000 |
Sales volume | 60 | 10 | 20 | |
Subcategory, CVP Model Results | MidLine | HighLine | LowLine | Total |
Sales | $ 390,000 | $ 110,000 | $ 80,000 | $ 580,000 |
Variable costs | 281,700 | 120,500 | 63,600 | 465,800 |
Contribution margin | Single Line108,300 | Single Line(10,500) | Single Line16,400 | Single Line114,200 |
Fixed costs | 71,667 | 15,111 | 23,222 | 110,000 |
Operating income | Single Line$ 36,633Double line | Single Line$ (25,611)Double line | Single Line$ (6,822)Double line | Single Line$ 4,200Double line |
Notice that when we allocate fixed costs, although the LowLine shows a positive contribution margin, it shows an operating loss. Total contribution margin based on sales of 20 units per month does not cover that model’s allocated fixed costs.
Let’s see what happens if we eliminate the HighLine and fixed costs do not change:
We have to reallocate rent on the production facility. For purposes of this analysis, let’s assume the 4,000 square feet HighLine production space either remains vacant or the MidLine and LowLine production lines spread a bit and take up that space. In either case, we have to reassess the amount of rent we will allocate to each segment, assuming the rent can’t go down just because we aren’t using that space:
Production facility usage | MidLine | HighLine | LowLine | Total |
---|---|---|---|---|
Square feet | 8,000 | – | 2,000 | 10,000 |
Allocation rate | 80.00% | 0.00% | 20.00% | 100.00% |
Let’s also, for now, assume that SG&A and sales salaries remain the same but are now allocated over fewer units:
Sales Salaries and SG&A | MidLine | HighLine | LowLine | Total |
---|---|---|---|---|
Unit sold | 60 | – | 20 | 80 |
Allocation rate | 75.00% | 0.00% | 25.00% | 100.00% |
Fixed costs allocated over two segments instead of three look like this:
Fixed costs per month | MidLine | HighLine | LowLine | Total |
---|---|---|---|---|
Sales Salary | $7,500 | $2,500 | $10,000 | |
Selling, General, and Administrative | 67,500 | 22,500 | 90,000 | |
Production Facility Rent | 8,000 | 2,000 | 10,000 | |
Single Line$83,000Double line | Single LineDouble line | Single Line$27,000Double line | Single Line$110,000Double line |
Notice that total fixed costs remain the same in this analysis, as does the bottom line, but the LowLine model fares even worse:
MidLine | HighLine | LowLine | Total | |
---|---|---|---|---|
Subcategory, Assumptions | ||||
Sales price per unit | $6,500 | $11,000 | $4,000 | |
Variable cost per unit | $4,695 | $12,050 | $3,180 | |
CM per unit | Single Line$1,805Double line | Single Line($1,050)Double line | Single Line$820Double line | |
Fixed costs per month | $83,000 | $0 | $27,000 | $110,000 |
Sales volume | 60 | – | 20 | |
Subcategory, CVP Model Results | MidLine | HighLine | LowLine | Total |
Sales | $ 390,000 | $ 80,000 | $ 470,000 | |
Variable costs | 281,700 | 63,600 | 345,300 | |
Contribution margin | Single Line108,300 | Single Line | Single Line16,400 | Single Line124,700 |
Fixed costs | 83,000 | 27,000 | 110,000 | |
Operating income | Single Line$ 25,300Double line | Single LineDouble line | Single Line$ (10,600)Double line | Single Line$ 14,700Double line |
Now let’s re-run this analysis with the assumption that by eliminating the HighLine model, which was sales-intensive, we could lay off one of the two salespeople, saving the company $5,000 per month, and cut SG&A by $10,000. Our fixed costs now look like this:
Fixed costs per month | MidLine | HighLine | LowLine | Total |
---|---|---|---|---|
Sales Salary | $ 3,750 | $ 1,250 | $ 5,000 | |
Selling, General, and Administrative | 60,000 | 20,000 | 80,000 | |
Production Facility Rent | 8,000 | 2,000 | 10,000 | |
Single Line$ 71,750Double line | Single LineDouble line | Single Line$ 23,250Double line | Single Line$ 95,000Double line |
And our CVP analysis looks like this:
MidLine | HighLine | LowLine | Total | |
---|---|---|---|---|
Subcategory, Assumptions | ||||
Sales price per unit | $6,500 | $11,000 | $4,000 | |
Variable cost per unit | $4,695 | $12,050 | $3,180 | |
CM per unit | Single Line$1,805Double line | Single Line($1,050)Double line | Single Line$820Double line | |
Fixed costs per month | $71,750 | $0 | $23,250 | $95,000 |
Sales volume | 60 | – | 20 | |
Subcategory, CVP Model Results | MidLine | HighLine | LowLine | Total |
Sales | $ 390,000 | $0 | $ 80,000 | $ 470,000 |
Variable costs | 281,700 | $0 | 63,600 | 345,300 |
Contribution margin | Single Line108,300 | Single Line$0 | Single Line16,400 | Single Line124,700 |
Fixed costs | 71,750 | $0 | 23,250 | 95,000 |
Operating income | Single Line$ 36,550Double line | Single Line$0Double line | Single Line$ (6,850)Double line | Single Line$ 29,700Double line |
Let’s look at this using differential analysis:
Description | Amount | Total |
---|---|---|
Expected decrease in revenue | ($110,000) | |
Expected decrease in total variable costs | $120,500 | |
Expected decrease in fixed costs | $15,000 | |
Expected decrease in total costs | Single Line | $135,500 |
Expected increase/(decrease) in operating income | Single Line$25,500Double line | |
Current operating income | $4,200 | |
Expected increase/(decrease) in operating income | $25,500 | |
Projected operating income | Single Line$29,700Double line |
Eliminating the HighLine and cutting costs increase the bottom line by $25,500 per month. That’s $306,000 per year.
However, we still have three questions left to answer.
Before we address those last three considerations, check your understanding of how changing the product mix affects fixed costs.
Practice Question
Candela Citations
- Fixed Costs. Authored by: Joseph Cooke. Provided by: Lumen Learning. License: CC BY: Attribution